Thursday, June 3, 2010

Burton Malkiel on Social Security reform

Burton Malkiel, Princeton economics professor and author of my favorite investing book – A Random Walk Down Wall Street – writes in today's Wall Street Journal that taking on Social Security reform would be a good start to fixing the budget. "Almost more important than the progress that would be made in bringing the long-run fiscal deficit under control," Malkiel argues, "would be the psychological message that our political process is actually capable of tackling entitlements. Markets everywhere would celebrate our return to fiscal sanity on at least one entitlement program."

Here's what Malkiel proposes:

Retirement ages. Life expectancy has increased by almost a decade since Social Security was introduced in the 1930s. But we've made only the smallest changes in retirement ages. We could increase the current retirement age schedule by one month a year for the next 36 years—i.e., a total of three years by 2046. After that, retirement ages could be further adjusted with changes in life expectancy. Workers in their 50s might have to work one additional year. We know that those who work after their "normal" retirement age are generally healthier, happier and more mentally alert and engaged than those who don't. Those who are unable to work would be allowed to retire under current schedules. Surveys suggest that younger workers, skeptical that Social Security will be able to pay the present schedule of benefits, would welcome putting Social Security on a sustainable basis.

Revise the indexing formula. Initial Social Security benefits are based on actual monthly earnings during the 35 years in which the person earned the most. These earnings are then indexed to account for changes in average wages since the year in which earnings were received. The indexing formula used to be based on increases in the consumer price index (CPI). During the Carter administration, the index was changed to average wages rather than prices. Changing the formula back to using CPI rather than average wage increases would make a substantial difference in the projected Social Security deficit over the next 75 years.

A proposal more favorable for low-wage earners is called "Progressive Price Indexing." Under this proposal, low earners would continue to receive benefits promised under "wage indexing," while high earners would have their initial benefits calculated under a formula that used "price indexing" instead. Social Security actuaries have estimated that Progressive Price Indexing could reduce the actuarial deficit by more than 70% of the 75-year shortfall.

Changes in the amount of earning subject to Social Security tax. As of 2009, $106,800 of earnings was subject to Social Security tax. That number could be increased to $125,000 or even $150,000. While this would represent a tax increase, it would leave the top marginal tax rate—crucial for preserving incentives—unchanged.

Malkiel's discussion of wage versus price indexing in the benefit formula isn't quite right. He's correct that the formula "indexes" past earnings to wage growth, but that's not what makes the system "wage indexed," by which we mean that benefits rise from cohort to cohort at the rate of wages, thereby keeping the replacement rate – the ratio of benefits to pre-retirement earnings – constant.

Wage indexing is accomplished through the part of the benefit formula known as "bend points," which are the dollar break points at which Social Security replaces different shares of pre-retirement earnings. For 2010, the bend points occur at $761 and $4,586 in monthly earnings. Social Security replaces 90 percent of earnings up to $761, 32 percent of earnings from $761 through $4,586, and 15 percent of earnings above $4,586. The dollar figures are increased each year at the rate of wage growth; this means that as average pre-retirement earnings rise, benefits will tend to rise at the same rate. Before the 1970s Social Security's benefit formula wasn't wage indexed, although ad hoc benefit increases passed by Congress kept replacement rates from falling too much.

That technical issue aside, though, I could see Malkiel's ideas forming the basis of an eventual deal. The question is whether we wait to cut a deal until we're forced or if we act today to get ahead of the problem. I'm not feeling optimistic at the moment, but hope springs eternal.

3 comments:

Bruce Webb said...

The fundamental problem with the "Kick the Peasant so as to Reassure the Bond Market" approach of cutting SS benefits to address an "entitlements crisis" is that you can't get a good CBO if you exempt current and approaching retirement beneficiaries from thos cuts.

A central principle of both the Leninist Strategy of Butler and Germanis in 1983 and the Six Principles of CSSS was that benefits for these groups have to be held harmless. Which means even the draconian Simpson Plan of only exempting workers currently under 60 doesn't even begin to show results before 2016 while the Ryan Roadmap would show no savings at all untill current 55 year olds reach FRA, i.e. 2021 and so ouside the 10 year budget window altogether. Yeah you get a nice number when scoring PV of cuts measured over the Infinite Future Horizon, but you get bubkis when measuring deficits over the ten year window (due to the lag in phasing in cuts) and depending on assumptions might actually increase total Public Debt (since Trust Fund surpluses score as Debt).

Most semi-informed readers assume that 'debt', 'deficit' and 'unfunded liability' move in response to policy changes in the same directions and magnitudes. They don't. Public Debt increased in calender year 2000 even as both the Trust Funds and the General Fund were in surplus. Go figure.

Andno that is not a snarky throw away line, you really do need to go figure. Any plan that delays benefit cuts destroys your 10 year CBO score. And sense the Obama Commission has been sold as reducing 'debt' and 'deficit' and not 'unfunded liability' somebody has their butt in a crevice here.

Andrew G. Biggs said...

Bruce,
I think you've have a tough time finding actual reform legislation in which the 'peasants' do that badly; it's almost always high earners who bear the brunt of things, either on the tax or the benefit side.
That said, you're right that that it's hard to reduce current deficits/debt under current reform approaches; they just don't kick in that quickly. But I believe bond markets would be reassured if they thought that in decades ahead the fiscal situation would be improving, so they wouldn't feel reluctant to roll over existing debt.
You're also right about how reform may affect the debt. If we're focusing on total government debt, including trust funds, then reducing benefits or raising taxes won't have much of an effect -- less publicly held debt, more trust fund debt. I'll have to think more about that, since (as I discussed in a different post) there's some question over which measure of debt makes most sense.

Monty said...

Here's a thought:

Means test social security after a modest number of year of payments. I'm well off and will get more than I paid in SSI most probably (even though I maxed out most years). What I want is less from the government (means test me to reduce my payments at some point) AND DON'T INCREASE TAXES FOR OUR YOUNGEST TAXPAYERS.

I always find it interesting that some of you guys never suggest ways to reduce government largess.